** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549**

----

**FORM10-QSB**

----

ý         **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**Forthe quarterly period ended September 30, 2006**

**OR**

o         **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

**For thetransition period from                 to**

**CommissionFile Number  0-20191**

**INTRUSIONINC.**(Exact name of small business issuer as specified in its charter)

| **Delaware**                                                     |   | **75-1911917**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |

 

**1101East Arapaho Road, Suite 200, Richardson, Texas 75081**(Address of principal executive offices)(Zip Code)

**(972)234-6400**(Issuer’s telephone number, including area code)

**NotApplicable**Former name, if changed since last report)

* * * * * * * * **

Check whether the issuer (1) filed all reportsrequired to be filed by Section 13 or 15(d) of the Exchange Act during thepast 12 months (or for such shorter period that the issuer was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days:

Yes x   No o

Indicate by check mark whether the Registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act:   Yes o   No x

The number of shares outstanding of the Registrant’sCommon Stock, $0.01 par value, on November 3, 2006 was 7,046,213.

Transitional Small Business Disclosure Format (checkone):   Yes o   No x

 

----

 

**INTRUSIONINC.**

INDEX

 
| **PART I — FINANCIAL  INFORMATION**                                                                                   | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|
|                                                                                                                       |       |       |       |
| Item  1. Financial Statements                                                                                              |       |       |       |
|                                                                                                                       |       |       |       |
| Unaudited Condensed Consolidated Balance Sheets as of  September 30, 2006 and December 31, 2005                       |       |       |       |
|                                                                                                                       |       |       |       |
| Unaudited Condensed Consolidated Statements of  Operations for the three and nine months ended September 30, 2006 and 2005 | ** ** | ** ** | ** ** |
|                                                                                                                       |       |       |       |
| Unaudited Condensed Consolidated Statements of Cash  Flows for the nine months ended September 30, 2006 and 2005           |       |       |       |
|                                                                                                                       |       |       |       |
| Notes to Unaudited Condensed Consolidated Financial  Statements                                                            |       |       |       |
|                                                                                                                       |       |       |       |
| Item 2. Management’s Discussion and Analysis or Plan  of Operation                                                    |       |       |       |
|                                                                                                                       |       |       |       |
| Item 3. Controls and Procedures                                                                                            |       |       |       |
|                                                                                                                       |       |       |       |
| **PART  II — OTHER INFORMATION**                                                                                      |       |       |       |
|                                                                                                                       |       |       |       |
| Item  1. Legal Proceedings                                                                                                 |       |       |       |
|                                                                                                                       |       |       |       |
| Item 6.  Exhibits                                                                                                          |       |       |       |
|                                                                                                                       |       |       |       |
| Signature  Page                                                                                                            |       |       |       |

 

2

----

 

**PART I — FINANCIAL INFORMATION**

Item 1. FINANCIALSTATEMENTS

**INTRUSION INC. AND SUBSIDIARIES**UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS(In thousands, except par value amounts)
| ** **                                                                                                                            | ** ** | **September 30,   2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                            |       |                               |       |                        |       |
| Current Assets:                                                                                                                       |       |                               |       |                        |       |
| Cash and cash  equivalents                                                                                                            |       | $                                  | 300        |                        | $          | 2,844 |   |
| Short-term  investments                                                                                                               |       | —                             |       | 500                         |       |
| Accounts  receivable, less allowance for doubtful accounts of $89 in 2006 and $102  in 2005                                           |       | 921                                |       | 443                         |       |
| Inventories, net                                                                                                                      |       | 239                                |       | 373                         |       |
| Prepaid expenses                                                                                                                      |       | 63                                 |       | 191                         |       |
| Total current assets                                                                                                                  |       | 1,523                              |       | 4,351                       |       |
| Property and equipment,  net                                                                                                          |       | 179                                |       | 256                         |       |
| Other assets                                                                                                                          |       | 41                                 |       | 41                          |       |
| TOTAL ASSETS                                                                                                                          |       | $                                  | 1,743      |                        | $          | 4,648 |   |
|                                                                                                                                  |       |                               |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                        |       |                               |       |                        |       |
|                                                                                                                                  |       |                               |       |                        |       |
| Current Liabilities:                                                                                                                  |       |                               |       |                        |       |
| Accounts payable  and accrued expenses                                                                                                |       | $                                  | 932        |                        | $          | 1,142 |   |
| Deferred revenue                                                                                                                      |       | 361                                |       | 527                         |       |
| Total current  liabilities                                                                                                            |       | 1,293                              |       | 1,669                       |       |
|                                                                                                                                  |       |                               |       |                        |       |
| Stockholders’ Equity:                                                                                                            |       |                               |       |                        |       |
| Preferred stock,  $0.01 par value: Authorized Shares — 5,000                                                                     |       |                               |       |                        |       |
| Series 1 shares  issued and outstanding — 260 in 2006 and 2005  Liquidation preference of $1,331 as of September 30, 2006        |       | 918                                |       | 918                         |       |
| Series 2 shares  issued and outstanding — 460 in 2006 and 500 in 2005  Liquidation preference of $1,155 as of September 30, 2006 |       | 724                                |       | 787                         |       |
| Series 3 shares  issued and outstanding — 469 in 2006 and 565 in 2005  Liquidation preference of $1,026 as of September 30, 2006 |       | 667                                |       | 805                         |       |
| Common stock,  $0.01 par value:                                                                                                       |       |                               |       |                        |       |
| Authorized  shares — 80,000                                                                                                      |       |                               |       |                        |       |
| Issued shares —  7,056 in 2006 and 6,919 in 2005                                                                                 |       |                               |       |                        |       |
| Outstanding  shares — 7,046 in 2006 and 6,909 in 2005                                                                            |       | 71                                 |       | 69                          |       |
| Common stock  held in treasury, at cost — 10 shares                                                                              |       | (362                               | )          | (362                        | )          |
| Additional  paid-in capital                                                                                                           |       | 53,464                             |       | 52,994                      |       |
| Accumulated  deficit                                                                                                                  |       | (54,853                            | )          | (52,053                     | )          |
| Accumulated  other comprehensive loss                                                                                                 |       | (179                               | )          | (179                        | )          |
| Total stockholders’  equity                                                                                                      |       | 450                                |       | 2,979                       |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                       |       | $                                  | 1,743      |                        | $          | 4,648 |   |

 

See accompanyingnotes.

3

----

**INTRUSION INC. AND SUBSIDIARIES**UNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts)
| ** **                                                                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                 | ** ** | **September 30,  2006**     | ** ** | **September 30,  2005**    | ** ** | **September 30,  2006** | ** ** | **September 30,  2005** | ** ** |
| Net product  revenue                                                       |       | $                                | 1,465      |                            | $          | 1,589 |   | $ | 2,840 |   | $ | 3,783 |   |
| Net customer  support and maintenance revenue                              |       | 271                              |       | 389                             |       | 951 |   | 1,089 |   |
| Total revenue                                                              |       | 1,736                            |       | 1,978                           |       | 3,791 |   | 4,872 |   |
| Cost of product  revenue                                                   |       | 755                              |       | 789                             |       | 1,441 |   | 2,010 |   |
| Cost of customer  support and maintenance revenue                          |       | 23                               |       | 8                               |       | 183 |   | 54 |   |
| Total cost of  revenue                                                     |       | 778                              |       | 797                             |       | 1,624 |   | 2,064 |   |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Gross profit                                                               |       | 958                              |       | 1,181                           |       | 2,167 |   | 2,808 |   |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Operating  expenses:                                                       |       |                             |       |                            |       |   |   |   |   |
| Sales and marketing                                                        |       | 562                              |       | 797                             |       | 2,227 |   | 2,429 |   |
| Research and development                                                   |       | 272                              |       | 552                             |       | 1,679 |   | 1,957 |   |
| General and administrative                                                 |       | 306                              |       | 336                             |       | 1,039 |   | 868 |   |
| Severance and related costs                                                |       | —                           |       | —                          |       | — |   | 55 |   |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Operating loss                                                             |       | (182                             | )          | (504                            | )          | (2,778 | ) | (2,501 | ) |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Other income  (expense), net                                               |       | —                           |       | —                          |       | (65 | ) | 2 |   |
| Interest income,  net                                                      |       | 2                                |       | 23                              |       | 43 |   | 56 |   |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Loss before  income tax provision                                          |       | (180                             | )          | (481                            | )          | (2,800 | ) | (2,443 | ) |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Income tax  provision                                                      |       | —                           |       | —                          |       | — |   | — |   |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Net loss                                                                   |       | $                                | (180       | )                               | $          | (481 | ) | $ | (2,800 | ) | $ | (2,443 | ) |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Preferred stock  dividends accrued                                         |       | (44                              | )          | (44                             | )          | (132 | ) | (129 | ) |
| Beneficial  conversion feature on preferred stock                          |       | —                           |       | —                          |       | — |   | (919 | ) |
| Net loss  attributable to common stockholders                              |       | $                                | (224       | )                               | $          | (525 | ) | $ | (2,932 | ) | $ | (3,491 | ) |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Net loss per  share attributable to common stockholders, basic and diluted |       | $                                | (0.03      | )                               | $          | (0.08 | ) | $ | (0.42 | ) | $ | (0.56 | ) |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Weighted average common  shares outstanding, basic and diluted             |       | 7,046                            |       | 6,586                           |       | 7,025 |   | 6,270 |   |

 

See accompanyingnotes.

4

----

**INTRUSION INC. AND SUBSIDIARIES**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)
| ** **                                                                      | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                      | ** ** | **September 30,  2006**    | ** ** | **September 30,  2005** | ** ** |
| Operating Activities:                                                           |       |                            |       |   |   |
| Net loss                                                                        |       | $                               | (2,800     | ) | $ | (2,443 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:    |       |                            |       |   |   |
| Depreciation and  amortization                                                  |       | 80                              |       | 141 |   |
| Provision for  doubtful accounts                                                |       | (13                             | )          | (285 | ) |
| Stock based  compensation                                                       |       | 402                             |       | — |   |
| Changes in operating  assets and liabilities:                                   |       |                            |       |   |   |
| Accounts  receivable                                                            |       | (465                            | )          | 603 |   |
| Inventories                                                                     |       | 134                             |       | 431 |   |
| Prepaid expenses  and other assets                                              |       | 128                             |       | 227 |   |
| Accounts payable  and accrued expenses                                          |       | (209                            | )          | (291 | ) |
| Deferred revenue                                                                |       | (166                            | )          | (86 | ) |
| Net cash used in  operating activities                                          |       | (2,909                          | )          | (1,703 | ) |
| Investing Activities:                                                           |       |                            |       |   |   |
| Purchases of  short-term investments                                            |       | —                          |       | (2,350 | ) |
| Maturities of  short-term investments                                           |       | 500                             |       | 1,925 |   |
| Purchases of  property and equipment                                            |       | (3                              | )          | (136 | ) |
| Net cash provided by  (used in) investing activities                            |       | 497                             |       | (561 | ) |
| Financing Activities:                                                           |       |                            |       |   |   |
| Proceeds from the  exercise of employee stock options                           |       | 1                               |       | — |   |
| Dividends paid  on preferred stock                                              |       | (133                            | )          | (137 | ) |
| Proceeds from  the issuance of preferred stock and warrants, net                |       | —                          |       | 2,490 |   |
| Net cash provided by  (used in) financing activities                            |       | (132                            | )          | 2,353 |   |
|                                                                            |       |                            |       |   |   |
| Effect of foreign  currency translation adjustment on cash and cash equivalents |       | —                          |       | (6 | ) |
|                                                                            |       |                            |       |   |   |
| Net decrease in cash  and cash equivalents                                      |       | (2,544                          | )          | 83 |   |
| Cash and cash  equivalents at beginning of period                               |       | 2,844                           |       | 2,315 |   |
| Cash and cash  equivalents at end of period                                     |       | $                               | 300        |   | $ | 2,398 |   |
|                                                                            |       |                            |       |   |   |
| SUPPLEMENTAL DISCLOSURE  OF NON CASH FINANCING ACTIVITIES:                      |       |                            |       |   |   |
|                                                                            |       |                            |       |   |   |
| Fair value of warrants  issued in connection with sale of preferred stock       |       | $                               | —     |   | $ | 815 |   |
| Amortization of preferred stock beneficial conversion feature                   |       | $                               | —     |   | $ | 919 |   |

 

See accompanyingnotes.

5

----

**INTRUSION INC. AND SUBSIDIARIES**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.     Description of Business

We develop,market, and support a family of regulated information compliance and dataprivacy protection products, entity identification systems along with networkintrusion prevention and detection systems that address vital security issuesfacing organizations with mission critical business applications or housingclassified, confidential, or customer information assets.  Our products includeCompliance CommanderTM for regulated information and data privacy protection,TraceCopTM for entity identification and location, SpySnareTM for real-timeinline blocking of spyware and unwanted peer-to-peer applications, andSecureNetTM for network intrusion prevention and detection.

We market and distributeour products through a direct sales force to end-users and distributors and bynumerous domestic and international system integrators, managed serviceproviders and value-added resellers.  Ourend-user customers include high technology, manufacturing, telecommunications,transportation, health care, insurance, government entities, financialinstitutions, academic institutions and e-commerce.

We were organized inTexas in September 1983 and reincorporated in Delaware inOctober 1995.  For more than 15years, we provided local area networking equipment and were known as OpticalData Systems or ODS Networks.  OnJune 1, 2000, we changed our name from ODS Networks, Inc. toIntrusion.com, Inc., and our Nasdaq ticker symbol from ODSI to INTZ to reflectour focus on intrusion detection solutions. On November 1, 2001, we changed our name from Intrusion.com, Inc.to Intrusion Inc.

Our principal executiveoffices are located at 1101 East Arapaho Road, Suite 200, Richardson, Texas75081, and our telephone number is (972) 234-6400.  Our website URL is www.intrusion.com.  Information contained in or linked to ourwebsite are not a part of this report. References to “we,” “us” and “our” in this report refer to IntrusionInc. and its subsidiaries.

As of September 30, 2006,we had cash, cash equivalents and short-term investments in the amount ofapproximately $0.3 million, down from approximately $3.3 million as ofDecember 31, 2005.  The decrease incash and short-term investments funded our operations for the first nine monthsof 2006.  On March 29, 2006, weestablished a $1.0 million line of credit with Silicon Valley Bank.  Our existing cash resources, line of creditand revenues for the remainder of 2006 and 2007, may not provide sufficientcash resources to finance our operations and expected capital expenditures forthe next twelve months.  Therefore, it ispossible that we will need to seek additional debt or equity financing to fundour operations for the next year. Despite actions to reduce our costs and improve our profitability, ouroperating losses and net operating cash outflows may continue through thefourth quarter of 2006 and into 2007.  Wemay not be able to achieve the revenue and gross margin objectives necessarywithout obtaining additional equity financing. We do not currently have any arrangements for additional financing andwe may not be able to secure additional debt or equity financing on termsacceptable to us, or at all, at the time when we need such funding.  Additionally, we may not have sufficientavailability under our credit line when additional funds are needed.  We had approximately $487,000 available to borrowon our credit line as of September 30, 2006.

2.     Basis of Presentation

The accompanyingunaudited condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesfor interim financial information and with the instructions to Form 10-QSB andItem 310 of Regulation S-B.  Accordingly,they do not include all of the information and footnotes required by accountingprinciples generally accepted in the United States for complete financialstatements.  The December 31, 2005balance sheet was derived from audited financial statements, but does notinclude all the disclosures required by accounting principles generallyaccepted in the United States.  However,we believe that the disclosures are adequate to make the information presentednot misleading.  In our opinion, all theadjustments (consisting of normal recurring adjustments) considered necessaryfor fair presentation have been included. The results of operations for the three and nine month period endingSeptember 30, 2006 are not necessarily indicative of the results that may beachieved for the full fiscal year or for any future period.  The unaudited condensed consolidatedfinancial statements included herein should be read in conjunction with theconsolidated financial statements and notes thereto included in the Company’sannual report on Form 10-KSB for the year ended December 31, 2005.

6

----

3.     Inventories (In thousands)

 
|                          | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------|------------|------------------------------|------------|-----------------------------|------------|
|                     |       |                         |       |                        |       |
| Inventories  consist of: |       |                         |       |                        |       |
|                     |       |                         |       |                        |       |
| Finished goods           |       | $                            | 192        |                        | $          | 290 |   |
| Work in progress         |       | 8                            |       | 8                           |       |
| Demonstration  systems   |       | 39                           |       | 75                          |       |
| Net inventory            |       | $                            | 239        |                        | $          | 373 |   |

 

4.     Accounting for Stock-Based Compensation

InDecember 2004, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment”(SFAS 123(R)), which replaces SFAS 123 and supersedes APB Opinion No. 25.  SFAS 123(R) requires all share-based paymentsto employees, including grants of employee stock options, to be recognized inthe financial statements based on their fair values. The pro forma disclosurespreviously permitted under SFAS 123 no longer will be an alternative tofinancial statement recognition.

Prior to January 1, 2006,we accounted for employee stock-based compensation in accordance with APB 25and followed the disclosure requirements in accordance with SFAS 148.  No compensation cost was recorded for stockoptions, as all options granted under the plans have an exercise price equal(at minimum) to the market value of the underlying common stock on the date ofgrant.

Weadopted SFAS 123(R) on January 1, 2006 using the modified prospectiveapplication method described in the statement. Results for prior periods havenot been restated.  Stock-basedcompensation expense recognized during the period is based on the value of theportion of stock-based payment awards that is ultimately expected to vest.  Stock-based compensation expense recognizedin the condensed consolidated statement of operations during 2006 includedcompensation expense for stock-based payment awards granted prior to, but notyet vested, as of December 31, 2005 based on the grant date fair valueestimated in accordance with the pro forma provisions of SFAS 148 andcompensation expense for the stock-based payment awards granted subsequent toDecember 31, 2005, based on the grant date fair value estimated in accordancewith SFAS 123(R).  As stock-basedcompensation expense recognized in the statement of operations after December31, 2005 is based on awards ultimately expected to vest, it has been reducedfor estimated forfeitures.  SFAS 123(R)requires forfeitures to be estimated at the time of grant and revised, ifnecessary, in subsequent periods if actual forfeitures differ from thoseestimates.  In the pro forma informationrequired under SFAS 148 for the periods prior to 2006, we accounted forforfeitures as they occurred.

Byadopting SFAS 123(R) we will record substantial non-cash stock compensationexpenses. The adoption of SFAS 123(R) is not expected to have a significanteffect on our financial condition or cash flows but is expected to have asignificant, adverse effect on our results of operations.

AtSeptember 30, 2006, we had three stock-based compensation plans, which aredescribed below. These plans were developed to retain and attract key employeesand directors.

In1995, we adopted our 1995 Stock Option Plan (the “1995 Plan”), which providesfor the issuance of up to 400,000 shares of common stock upon exercise ofoptions granted pursuant to the 1995 Plan. On April 26, 2001, ourstockholders increased the overall number of shares available for issuancepursuant to the plan to 825,000 shares of common stock. The 1995 Plan providesfor the issuance of both non-qualified and incentive stock options to our employees,officers, and employee-directors. The 1995 Plan expired by its terms on March21, 2005 and no options were available for future issuance after theexpiration.  At September 30, 2006,67,365 employee options have been exercised and employee options to purchase atotal of 497,677 shares of common stock are outstanding.  A total of 2,290,295 options have beengranted pursuant to the 1995 Plan, of which, 1,725,253 have been cancelled.

In 1995, we alsoadopted the 1995 Non-Employee Director Stock Option Plan (the “1995Non-Employee Director Plan”).  The 1995Non-Employee Director Plan provided for the issuance of non-qualified stockoptions to non-employee directors. The 1995 Non-Employee Director Plan wasamended in April 2002 to increase the number of shares available for issuanceto 65,000 from 40,000 shares. The 1995 Non-Employee Director Plan expiredby its terms on March 21, 2005 and no options were available for futureissuance after the expiration.  Nooptions have been exercised under the 1995 Non-Employee Director Plan.  Non-employee options to purchase a total of32,500 shares of common stock are outstanding at September 30, 2006. Atotal of 62,500 options have been granted to directors pursuant to the 1995Non-Employee Director Plan, of which, 30,000 have been cancelled.

7

----

On March 17, 2005,the Board approved the 2005 Stock Incentive Plan (the “2005 Plan”), which wasapproved by the stockholders on June 14, 2005. The 2005 Plan serves as a replacement for the 1995 Non-Employee DirectorPlan and the 1995 Option Plan which expired by their terms on March 21,2005.  The approval of the 2005 Plan hadno effect on the 1995 Plans or any options granted pursuant to eitherplan.  All options will continue withtheir existing terms and will be subject to the 1995 Non-Employee Director Planor the 1995 Plan, as applicable. Further, the Company will not be able to re-issue any option which iscancelled or terminated under the 1995 Non-Employee Director Plan or the 1995Option Plan.  The 2005 Plan provides forthe issuance of up to 750,000 shares of common stock upon exercise of optionsgranted pursuant to the 2005 Plan.  The2005 Plan consists of three (3) separate equity incentive programs: theDiscretionary Option Grant Program; the Stock Issuance Program; and theAutomatic Option Grant Program for non-employee Board members.  Officers and employees, non-employee Boardmembers and independent contractors are eligible to participate in theDiscretionary Option Grant and Stock Issuance Programs.  Participation in the Automatic Option GrantProgram is limited to non-employee members of the Board.  Each non-employee Board member will receivean option grant for 10,000 shares of Common Stock upon initial election orappointment to the Board, provided that individual has not previously beenemployed by the Company in the preceding six (6) months.  In addition, on the date of each annualstockholders meeting, each Board member will automatically be granted an optionto purchase 5,000 shares of Common Stock, provided he or she has served as anon-employee Board member for at least six (6) months.  At September 30, 2006, no 2005 plan optionshave been exercised and employee and non-employee Board member options topurchase a total of 326,000 shares of common stock are outstanding.  A total of 348,000 options have been grantedunder the 2005 Plan, of which 22,000 have been cancelled and options for424,000 shares remain available for future grant.  No shares have been issued pursuant to theStock Issuance Program.

TheCompensation Committee of our Board of Directors determines for all employeeoptions, the term of each option, option exercise price within limits set forthin the plans, number of shares for which each option is granted and the rate atwhich each option is exercisable (generally ratably over one, three or fiveyears from grant date).  However, theexercise price of any incentive stock option may not be less than the fairmarket value of the shares on the date granted (or less than 110% of the fairmarket value in the case of optionees holding more than 10% of our voting stockof the Company), and the term cannot exceed ten years (five years for incentivestock options granted to holders of more than 10% of our voting stock).

Effect of Adopting SFASNo. 123(R)

The following is theeffect of adopting SFAS No. 123(R) as of January 1, 2006 for the three and ninemonths ended September 30, 2006 (in thousands, except per share data).
|                                                                          | ** ** | **For Three Months  Ended  September 30, 2006** | ** ** | **For Nine Months  Ended  September 30, 2006** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
|                                                                     |       |                                                                |       |                                                               |       |
| Stock-option  compensation expense recognized  (for stock options only): |       |                                                                |       |                                                               |       |
| Cost of revenue                                                          |       | $                                                                   | 1     |                                                               | $          | 24  |   |
| Research and development                                                 |       | 15                                                             |       | 94                                                            |       |
| Sales and marketing                                                      |       | 16                                                             |       | 164                                                           |       |
| General and administrative                                               |       | 7                                                              |       | 120                                                           |       |
| Effect on net  loss                                                      |       | $                                                                   | 39    |                                                               | $          | 402  |   |
| Effect on basic and  diluted earnings per common share                   |       | $                                                                   | (0.01)     |                                                               | $          | (0.06) |   |

 

ValuationAssumptions

Thefair values of option awards were estimated at the date of grant using aBlack-Scholes option-pricing model with the following assumptions (no optionswere granted during the three months ended September 30, 2006):

 
| ** **                              | ** ** | **For Three Months  Ended  September 30, 2006** | ** ** | **For Three Months  Ended  September 30, 2005** | ** ** | **For Nine Months  Ended  September 30, 2006** | ** ** | **For Nine  Months  September 30, 2005** | ** ** |
|-----------------------------------------|------------|---------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
|                                    |       |                                                                |       |                                                                |       |                                                               |       |                                                    |       |
| Weighted average  grant date fair value |       | n/a                                                                 |       | $                                                                   | 2.29       |                                                               | $          | 1.03                                                    |       | $ | 2.35 |   |
| Weighted average  assumptions used:     |       |                                                                |       |                                                                |       |                                                               |       |                                                    |       |
| Expected dividend yield                 |       | n/a                                                                 |       | 0.0                                                                 | %          | 0.0                                                                | %          | 0.0                                                     | %          |
| Risk-free interest rate                 |       | n/a                                                                 |       | 4.2                                                                 | %          | 4.6                                                                | %          | 3.9                                                     | %          |
| Expected volatility                     |       | n/a                                                                 |       | 104.0                                                               | %          | 98.6                                                               | %          | 113.1                                                   | %          |
| Expected life  (in years)               |       | n/a                                                                 |       | 5.0                                                                 |       | 5.0                                                                |       | 4.4                                                     |       |
|                                         |            |                                                                     |            |                                                                     |            |                                                                    |            |                                                         |            |  |  |  |

 

8

----

TheBlack-Scholes option valuation model was developed for use in estimating thefair value of traded options that have no vesting restrictions and are fullytransferable. In addition, option valuation models require the input of highlysubjective assumptions including the expected stock price volatility. Becauseour employee stock options have characteristics significantly different fromthose of traded options, and because changes in the subjective inputassumptions can materially affect the fair value estimate, in management’sopinion, the existing models do not necessarily provide a reliable singlemeasure of the fair value of its employee stock options.

Expectedvolatility is based on historical volatility and in part on impliedvolatility.  The expected term considersthe contractual term of the option as well as historical exercise andforfeiture behavior.  The risk-freeinterest rate is based on the rates in effect on the grant date for U.S.Treasury instruments with maturities matching the relevant expected term of theaward.

Stock IncentivePlan Activity

Stockoption activity under the Company’s various long-term incentive and directorcompensation plans during the nine months ended September 30, 2006, were asfollows:

|                                    | ** ** | **Number of  Options  (in thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------|------------|
| ** **                         | ** ** | ** **                                       | ** ** | ** **                             | ** ** |
| Outstanding at  December 31, 2005  |       | 891                                         |       | $                                      | 5.48       |   |
| Granted                            |       | 48.0                                        |       | 1.37                                   |       |
| Exercised                          |       | (1)                                              |       | 0.76                                   |       |
| Forfeited                          |       | (54)                                             |       | 2.72                                   |       |
| Expired                            |       | (28)                                             |       | 8.24                                   |       |
|                               |       |                                             |       |                                   |       |
| Outstanding at  September 30, 2006 |       | 856                                         |       | $                                      | 5.34       |   |

 

Stock OptionsOutstanding and Exercisable

Summarizedinformation about outstanding stock options as of September 30, 2006, that arefully vested and those that are expected to vest in the future as well as stockoptions that are fully vested and currently exercisable, are as follows:

 

|                                              | ** ** | **Outstanding Stock  Options (Fully Vested and  Expected to Vest)*** | ** ** | **Options that are  Exercisable** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **As of September 30, 2006**                 | ** ** | ** **                                                                                         | ** ** | ** **                                  | ** ** |
| Number of outstanding options                |       | 856                                                                                                |       | 683                                         |       |
| Weighted average remaining  contractual life |       | 7.47                                                                                               |       | 7.16                                        |       |
| Weighted average exercise price per share    |       | $                                                                                                  | 5.34       |                                        | $          | 6.08 |   |
| Intrinsic value                              |       | $                                                                                                  | 0          |                                        | $          | 0 |   |
|                                         |       |                                                                                               |       |                                        |       |
| * Includes effects of  expected forfeitures  |       |                                                                                               |       |                                        |       |

 

Theoptions detailed in the table above have a $0 intrinsic value as the fairmarket value on September 30, 2006 is less than the exercise prices of all ofthe options vested and expected to vest. As of September 30, 2006, the totalunrecognized compensation cost related to non-vested options not yet recognizedin the statement of operations totaled approximately $118 thousand and theweighted period over which these awards are expected to be recognized was 1.02years.

9

----

Pro Forma Presentation for Periods Prior to theAdoption of SFAS 123(R)

Under the modifiedprospective application method, results for prior periods have not beenrestated to reflect the effects of implementing SFAS No. 123(R).  The following pro forma information wasreported, as required by SFAS No. 148, “Accounting for Stock-Based Compensation— Transition and Disclosure” for the quarter and nine months ended September30, 2005.

|                                                                                                  | ** ** | **Quarter  Ended  September 30, 2005** | ** ** | **Nine  Months  September 30, 2005** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
|                                                                                             |       |                                             |       |                                           |       |
| Net loss  attributable to common stockholders                                                    |       | $                                                | (525)      |                                           | $          | (3,491) |   |
| Deduct: Total  stock-based compensation determined under fair value-based method for all  awards |       | (283)                                            |       | (589)                                          |       |
| Pro forma net  loss attributable to common stockholders                                          |       | $                                                | (808)      |                                           | $          | (4,080) |   |
| Net loss per  share attributable to common stockholders:                                         |       |                                             |       |                                           |       |
| as reported (basic and diluted)                                                                  |       | $                                                | (0.08)     |                                           | $          | (0.56) |   |
| pro forma (basic and diluted)                                                                    |       | $                                                | (0.12)     |                                           | $          | (0.65) |   |
| Weighted-average  shares used in computation:                                                    |       |                                             |       |                                           |       |
| Basic and  diluted                                                                               |       | 6,586                                       |       | 6,270                                     |       |

 

5.     Net Loss Per Share

Basic net loss per shareis computed by dividing net loss attributable to common stockholders for theperiod by the weighted average number of common shares outstanding for theperiod.  Diluted net loss per share iscomputed by dividing the net loss attributable to common stockholders by theweighted average number of common shares and common stock equivalentsoutstanding for the period.  Our commonstock equivalents include all common stock issuable upon conversion ofpreferred stock and the exercise of outstanding options and warrants.  The aggregate number of common stockequivalents excluded from the loss per share calculation for the three and ninemonth periods ended September 30, 2006 and 2005 are 3,721,769 and 3,247,451,respectively.  Our common stockequivalents are not included in the diluted loss per share for the periodsended September 30, 2006 and 2005, as they are antidilutive.

6.     Commitments and Contingencies

We are subject to legalproceedings and claims that arise in the ordinary course of business.  We do not believe that the outcome of thosematters will have a material adverse affect on our consolidated financial position,operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact**.**

7.     Preferred Stock and Common Stock

During the ninemonths ended September 30, 2006, no shares of our preferred stock wereconverted into common stock. At September 30, 2006, there are 259,696 shares of5% preferred stock outstanding, 460,000 shares of Series 2 5% preferred stockoutstanding and 468,735 shares of Series 3 5% preferred stock outstanding.  In addition, an employee exercised stockoptions to purchase 834 shares of common stock during the nine months endedSeptember 30, 2006.

 

10

----

Item 2.           MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This report containsforward-looking statements, within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934.  Such forward-looking statementsare generally accompanied by words such as “plan,” “estimate,” “expect,” “believe,”“should,” “would,” “could,” “anticipate,” “may” or other words that conveyuncertainty of future events or outcomes. These forward-looking statements and other statements made elsewhere inthis report are made in reliance on the Private Securities Litigation ReformAct of 1995.  These statements aresubject to certain risks and uncertainties, such as the risk that we may haveinsufficient cash resources to fund our current operations, difficulties inforecasting future sales caused by current economic and market conditions, theeffect of military actions on government and corporate spending on informationsecurity products, spending patterns of, and appropriations to, U.S. governmentdepartments, the impact of our cost reduction programs and our refocusedproduct line, the difficulties and uncertainties in successfully developing andintroducing new products, market acceptance of our products, the impact ofsustained losses on our ability to successfully operate and grow our business,our stock price and our loss of Nasdaq eligibility, the highly competitivemarket for our products, the effects of sales and implementation cycles for ournew products on our quarterly results, difficulties in accurately estimatingmarket growth, the consolidation of the information security industry, theimpact of changing economic conditions, business conditions in the informationsecurity industry, our ability to manage acquisitions effectively, our abilityto manage discontinued operations effectively, the impact of market peers andtheir products as well as risks concerning future technology and othersidentified in our Annual Report on Form 10-KSB and other Securities andExchange Commission filings.  Thesection below entitled “Factors That May Affect Future Results ofOperations” sets forth and incorporates by reference certain risks that couldcause actual future results of the Company to differ materially from any suchforward looking statements.

Critical Accounting Policies and Estimates

Management’s discussionand analysis of financial condition and results of operations are based uponour unaudited condensed consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States.  The preparation of thesefinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingent assets and liabilities.  On an on-going basis, we evaluate ourestimates, including those related to product returns, bad debts, inventories,income taxes, warranty obligations, restructuring, maintenance contracts andcontingencies.  We base our estimates onhistorical experience and on various other assumptions that we believe arereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.

We believe the followingcritical accounting policies affect our more significant judgments andestimates used in the preparation of our unaudited condensed consolidatedfinancial statements.

*RevenueRecognition*

Wegenerally recognize product revenue upon shipment of product. We accrue forestimated warranty costs and sales returns at the time of shipment based on ourexperience. Revenue from maintenance contracts is deferred and recognized overthe contractual period the services are performed, generally one year.  There is a risk that technical issues on newproducts could result in unexpected warranty costs and returns.  However, as we migrate to more of asoftware-based business model, the warranty costs should continue todecline.  To the extent that they dodecline, our warranty reserve from current sales will decrease.  To the extent that our warranty costs exceedour expectations, we will increase our warranty reserve to compensate for theadditional expense expected to be incurred. We review these estimates periodically and determine the appropriate reservepercentage.  However, to date, warrantycosts and sales returns have not been material. Historically, our estimates for these items have not differed materiallyfrom actual results.  Significant orsubjective estimates associated with our revenue recognition policy include ourestimate of warranty cost and sales returns.

Werecognize software revenue from the licensing of our software products inaccordance with Statement of Position (“SOP”) No. 97-2 “Software RevenueRecognition”, SOP 98-9 “Modification of 97-2, Software Revenue Recognition,with respect to certain transactions” and Staff Accounting Bulletin (“SAB”) No.104, “Revenue Recognition” whereby revenue from the licensing of our productsis not recognized until all four of the following criteria have been met:(1) execution of a written agreement; (2) delivery of the product hasoccurred; (3) the fee is fixed and determinable; and(4) collectibility is probable. Bundled hardware and perpetual softwareproduct sales are recognized at time of delivery, as our licenses are not soldon a subscription basis.  In the case ofmultiple product and service sales, we perform a Vendor Specific ObjectiveEvidence analysis to appropriately determine the amount of revenue derived fromeach deliverable.  If our licensestrategy changes and we begin to offer licenses on a subscription basis, wewould perform this analysis in a similar manner.  Under these circumstances, the revenuerelated to the license would be recognized ratably over the subscription period.  Market values are easily obtained for all ofour product offerings, as we have historical sales information on our productofferings.  We defer and recognizemaintenance and support revenue over the term of the contract period, which isgenerally one year.

11

----

Wehave signed distribution agreements with distributors in the United States,Europe and Asia. In general, these relationships are non-exclusive.Distributors typically maintain an inventory of our products. Under theseagreements, we provide certain protection to the distributors for theirinventory of our products for price reductions as well as products that areslow moving or have been discontinued by us. Historically, returns from ourdistributors and charges related to price reductions on inventory held bydistributors have not been material. Recognition of sales to distributors and related gross profits aredeferred until the distributors resell the merchandise. However, since we havelegally sold the inventory to the distributor and we no longer have care,custody or control over the inventory, we recognize the trade accountsreceivable and reduce inventory related to the sale at the time of shipment tothe distributor. Revenue, offset by deferred cost of sales, is included indeferred revenue in the accompanying financial statements.  Since the net balance in deferred revenuerepresents the sales price less the cost of the product maintained by thedistributors, the deferred costs of these products are included in ourobsolescence and slow-moving analysis and are written down according to theirestimated current value.  Thistransaction effectively recognizes expense for the write-down, if any, andincreases the net liability in the deferred revenue account.

Wegenerally recognize service revenue upon delivery of the contracted service.  Service revenue, primarily includingmaintenance, training and installation, are recognized upon delivery of theservice and typically are unrelated to product sales.  These services are not essential to thefunctionality of the delivered product. To date, training and installation revenue has not been material.

*Allowancefor Doubtful Accounts and Returns*

Wemaintain allowances for doubtful accounts for estimated losses resulting fromthe inability of our customers to make required payments. Our receivables areuncollaterized and we expect to continue this policy in the future.  If the financial condition of our customerswere to deteriorate, resulting in an impairment of their ability to makepayments, additional allowances may be required.  Historically, our estimates for sales returnsand doubtful accounts have not differed materially from actual results.

*Inventory*

We write down ourinventory for estimated obsolescence or unmarketable inventory equal to thedifference between the cost of inventory and the estimated market value basedupon assumptions about future demand and market conditions. If actual marketconditions are less favorable than those projected by management, additionalinventory write-downs may be required. Historically, our estimates for inventory obsolescence have not differedmaterially from actual results.

*Stock-based Compensation*

Beginning on January 1,2006, we began accounting for stock options under the provisions of FinancialAccounting Standards No. 123 (revised 2004), “Share-Based Payment” (FAS123(R)), which requires the recognition of the fair value of stock-basedcompensation.  Under the fair valuerecognition provisions for FAS 123(R), stock-based compensation cost isestimated at the grant date based on the fair value of the awards expected tovest and recognized as expense ratably over the requisite service period of theaward.  We have used the Black-Scholesvaluation model, to estimate fair value of our stock-based awards which requiresvarious judgmental assumptions including estimating stock price volatility,forfeiture rates, and expected life.  Ourcomputation of expected volatility is based on a combination of historical andmarket-based implied volatility.  Inaddition, we consider many factors when estimating expected forfeitures andexpected life, including types of awards, employee class, and historicalexperience.  If any of the assumptionsused in the Black-Scholes model change significantly, stock-based compensationexpense may differ materially in the future from that recorded in the currentperiod.

We adopted FAS 123(R)using the modified prospective method which requires the application of theaccounting standard as of January 1, 2006. In accordance with the modified prospective method, the consolidated financialstatements for prior periods have not been restated to reflect, and do notinclude, the impact of FAS 123(R).

12

----

Results of Operations

The following table setsforth, for the periods indicated, certain financial data as a percentage of netrevenues. The period-to-period comparison of financial results is notnecessarily indicative of future results.

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | **Sept 30, 2006**      | ** ** | **Sept 30, 2005**     | ** ** | **Sept 30, 2006** | ** ** | **Sept 30, 2005** | ** ** |
| Net product  revenue                              |       | 84.4                             | %          | 80.3                            | %          | 74.9 | % | 77.6 | % |
| Net customer  support and maintenance revenue     |       | 15.6                             |       | 19.7                            |       | 25.1 |   | 22.4 |   |
| Total revenue                                     |       | 100.0                            |       | 100.0                           |       | 100.0 |   | 100.0 |   |
| Cost of product  revenue                          |       | 43.5                             |       | 39.9                            |       | 38.0 |   | 41.3 |   |
| Cost of customer  support and maintenance revenue |       | 1.3                              |       | 0.4                             |       | 4.8 |   | 1.1 |   |
| Total cost of  revenue                            |       | 44.8                             |       | 40.3                            |       | 42.8 |   | 42.4 |   |
| Gross profit                                      |       | 55.2                             |       | 59.7                            |       | 57.2 |   | 57.6 |   |
| Operating  expenses:                              |       |                             |       |                            |       |   |   |   |   |
| Sales and marketing                               |       | 32.4                             |       | 40.3                            |       | 58.7 |   | 50.0 |   |
| Research and development                          |       | 15.7                             |       | 27.9                            |       | 44.3 |   | 40.2 |   |
| General and administrative                        |       | 17.6                             |       | 17.0                            |       | 27.4 |   | 17.8 |   |
| Severance and related costs                       |       | —                           |       | —                          |       | — |   | 1.1 |   |
| Operating loss                                    |       | (10.5                            | )          | (25.5                           | )          | (73.3 | ) | (51.3 | ) |
|                                              |       |                             |       |                            |       |   |   |   |   |
| Other income  (expense), net                      |       | —                           |       | —                          |       | (1.7 | ) | 0.0 |   |
| Interest income,  net                             |       | 0.1                              |       | 1.2                             |       | 1.1 |   | 1.1 |   |
| Loss before  income tax provision                 |       | (10.4                            | )          | (24.3                           | )          | (73.9 | ) | (50.2 | ) |
|                                              |       |                             |       |                            |       |   |   |   |   |
| Income tax  provision                             |       | —                           |       | —                          |       | — |   | — |   |
|                                              |       |                             |       |                            |       |   |   |   |   |
| Net loss                                          |       | (10.4                            | )%         | (24.3                           | )%         | (73.9 | )% | (50.2 | )% |
| Preferred stock  dividends accrued                |       | (2.5                             | )          | (2.2                            | )          | (3.5 | ) | (2.6 | ) |
| Beneficial  conversion feature on preferred stock |       | —                           |       | —                          |       | — | ) | (18.9 | ) |
|                                              |       |                             |       |                            |       |   |   |   |   |
| Net loss attributable  to common stockholders     |       | (12.9                            | )%         | (26.5                           | )%         | (77.3 | )% | (71.7 | )% |

 
| ** **           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **           | ** ** | **Sept 30, 2006**      | ** ** | **Sept 30, 2005**     | ** ** | **Sept 30, 2006** | ** ** | **Sept 30, 2005** | ** ** |
| Domestic  revenues   |       | 93.0                             | %          | 91.0                            | %          | 89.5 | % | 89.4 | % |
| Export revenues  to: |       |                             |       |                            |       |   |   |   |   |
| Europe               |       | 5.5                              |       | 7.3                             |       | 8.1 |   | 7.5 |   |
| Canada               |       | 1.0                              |       | 0.2                             |       | 1.3 |   | 0.5 |   |
| Asia                 |       | 0.4                              |       | 1.4                             |       | 1.0 |   | 2.5 |   |
| Latin America        |       | 0.1                              |       | 0.1                             |       | 0.1 |   | 0.1 |   |
|                 |       |                             |       |                            |       |   |   |   |   |
| Net revenues         |       | 100.0                            | %          | 100.0                           | %          | 100.0 | % | 100.0 | % |

 

**NetRevenues**.  Net revenuesfor the quarter and nine months ended September 30, 2006 decreased to $1.7million and $3.8 million, respectively, compared to $2.0 million and $4.9million for the same periods in 2005, primarily because of longer thananticipated sales cycles revolving around new product introductions as wecontinued our strategic move to concentrate on our entity identification andregulated information compliance and data privacy products.  Product revenues decreased $0.1 million and$0.9 million, respectively, for the quarter and nine months ended September 30,2006 compared to the same periods in 2005. Customer support and maintenance revenue for the quarter and nine monthsdecreased $0.1 million and $0.1 million, respectively compared to the sameperiods in 2005.

13

----

**Concentrationof Revenues**.  Revenuesfrom sales to various U.S. government entities totaled $1.3 million, or 73.8%of revenues, for the quarter ended September 30, 2006 compared to $1.5 million,or 77.0% of revenues, for the same period in 2005.  Revenues from sales to various U.S.government entities totaled $2.7 million, or 71.8% of revenues, for the ninemonths ended September 30, 2006 compared to $3.6 million, or 73.4% of revenues,for the same period in 2005.  Although,we expect our concentration of revenues to vary among customers in futurequarters depending upon the timing of certain sales, we anticipate that salesto government customers will continue to account for a significant portion ofour revenues in future quarters.  Salesto the government present risks in addition to those involved in sales tocommercial customers which could adversely affect our revenues, includingpotential disruption to appropriation and spending patterns and the government’sreservation of the right to cancel contracts and purchase orders for itsconvenience.  Although we do not believethat the cancellation of any particular order would have a material adverseeffect on our financial results or that any of our revenues with governmentcustomers are subject to renegotiation, a large number of cancelled orrenegotiated government orders could possibly have a material adverse effect onour financial results.  Currently, we arenot aware of any proposed cancellation or renegotiation of any of our existingarrangements with government entities and, historically, government entitieshave not cancelled or renegotiated orders which had a material adverse effecton our business.

**GrossProfit**.  Gross profitwas $1.0 million or 55.2% of net revenues for the quarter ended September 30,2006, compared to $1.2 million or 59.7% of net revenues for the quarter endedSeptember 30, 2005. Gross profit was $2.2 million or 57.2% of net revenues forthe nine months ended September 30, 2006, compared to $2.8 million or 57.6% ofnet revenues for the nine months ended September 30, 2005. Gross profit marginsas a percentage of net revenues decreased from the same period in the prioryear due to a shift in product mix. Gross profit on product revenues for thequarter and nine months ended September 30, was 50.3% and 46.9%, respectively,in 2005 and 48.4% and 49.3%, respectively, in 2006.  Gross profit on customer support andmaintenance revenues for the quarter and nine months ended September 30,decreased from 97.9% and 95.0%, respectively, in 2005 to 91.5% and 80.8%,respectively, in 2006, as more costs associated with maintenance contracts wereincurred during 2006.

Gross profit as apercentage of net revenues is impacted by several factors, including shifts inproduct mix, changes in channels of distribution, revenue volume, pricingstrategies, and fluctuations in revenues of integrated third-party products.

**Salesand Marketing**.  Salesand marketing expenses decreased to $0.6 million for the quarter endedSeptember 30, 2006, compared to $0.8 million for the quarter ended September30, 2005. Sales and marketing expenses decreased to $2.2 million for the ninemonths ended September 30, 2006, compared to $2.4 million for the nine monthsended September 30, 2005.  Sales andmarketing expenses may vary as a percentage of net sales in the future; however,we believe that these costs will trend constant to downward through the end ofthe year due to reductions in personnel and discretionary sales and marketingexpenditures.

**Researchand Development**. Research and development expenses decreased to $0.3 million for thequarter ended September 30, 2006 compared to $0.6 million for the quarter endedSeptember 30, 2005. Research and development expenses decreased to $1.7 millionfor the nine months ended September 30, 2006, compared to $2.0 million for thenine months ended September 30, 2005. Research and development costs areexpensed in the period incurred. Research and development expenses may vary as a percentage of net salesin the future; however, we believe that the downward trend in costs maycontinue through the end of the year as a result of additional engineeringexpenses incurred as cost of sales on development contracts.

**Generaland Administrative**. General and administrative expenses remained consistent at $0.3 millionfor the quarter ended September 30, 2006 compared to $0.3 million for thequarter ended September 30, 2005. General and administrative expenses increased to $1.0 million for thenine months ended September 30, 2006, compared to $0.9 million for the ninemonths ended September 30, 2005.  Thisincrease was primarily due to stock-based compensation expense totaling $120thousand recognized in 2006 under SFAS123(R). It is expected that general and administrative expenses will remainfairly constant through the end of the year because of cost containmentefforts.  General and administrativeexpense may vary as a percentage of net sales in the future.

**Interest**.  Net interest income decreased to $2 thousandfor the quarter ended September 30, 2006 compared to $23 thousand for the sameperiod in 2005.  Net interest incomedecreased to $43 thousand for the nine months ended September 30, 2006 comparedto $56 thousand for the same period in 2005. These decreases were primarily caused by lower cash and short-terminvestment balances in the periods.  Netinterest income may vary in the future based on our cash flow and rate ofreturn on investments.

 

14

----

Liquidity and Capital Resources

Our principal source ofliquidity at September 30, 2006 is approximately $0.3 million of cash and cashequivalents.  At September 30, 2006working capital was $0.2 million compared to $2.4 million at September 30, 2005.

Cash used in operationsfor the nine months ended September 30, 2006 was $2.9 million, primarily due toa net loss of $2.8 million, a decrease in accounts payable and accrued expensesof $0.2 million, a reduction in deferred revenue of $0.2 million, an increasein accounts receivable of $0.5 million and a reduction in the provision fordoubtful accounts of $13 thousand.  Thiscash decrease was partially offset by stock-based compensation of $0.4 million,depreciation expense of $80 thousand, a decrease in inventories of $134thousand and a decrease in prepaid expenses and other assets of $128thousand.  Cash used in operations forthe nine months ended September 30, 2005 was $1.7 million, primarily due to anet loss of $2.4 million, a decrease in accounts payable and accrued expensesof $0.3 million, a reduction in the provision for doubtful accounts of $0.3million and a reduction in deferred revenue of $0.1 million.  This cash decrease was partially offset bydepreciation expense of $0.1 million, a decrease in accounts receivable of $0.6million, a decrease in inventories of $0.4 million and a decrease in prepaidexpenses and other assets of $0.2 million.  Future fluctuations in inventory balances, accounts receivable andaccounts payable will be dependent upon several factors, including, but notlimited to, quarterly sales, our strategy in building inventory in advance ofreceiving orders from customers, and the accuracy of our forecasts of productdemand and component requirements.

Cash provided byinvesting activities in the nine months ended September 30, 2006 was $3thousand of net purchases of property and equipment offset by maturities ofshort-term investments of $0.5 million, compared to cash used in investingactivities of $0.6 million for the nine months ended September 30, 2005, whichconsisted primarily the purchase of short-term investments of $2.4 million andnet purchases of property and equipment of $0.1 million, which was offsetpartially by maturities of short-term investments of $1.9 million.

Cash used in financingactivities in the nine months ended September 30, 2006 was $0.1 million,primarily consisting of the payment of dividends on preferred stock, comparedto cash provided by financing activities in the nine months ended September 30,2005 was $2.4 million, consisting of net financing proceeds from a privateplacement of $2.5 million, partially offset by payment of dividends onpreferred stock of $137 thousand.

At September 30, 2006, the Company did not have any materialcommitments for capital expenditures.

During the nine months ended September 30, 2006, the Company funded itsoperations through the use of cash and cash equivalents.

As of September 30, 2006,we had cash, cash equivalents and short-term investments in the amount ofapproximately $0.3 million, down from approximately $3.3 million as ofDecember 31, 2005.  We funded ouroperations and met our cash requirements during the three months endedSeptember 30, 2006 through the use of cash and cash equivalents.  On March 29, 2006, we established a $1.0million line of credit with Silicon Valley Bank.  Our existing cash resources, line of creditand revenues for the remainder of 2006 and 2007, may not provide sufficientcash resources to finance our operations and expected capital expenditures forthe next twelve months.  Therefore, it ispossible that we will need to seek additional debt or equity financing to fundour operations for the next year. Despite actions to reduce our costs and improve our profitability, ouroperating losses and net operating cash outflows may continue through thefourth quarter of 2006 and into 2007.  Wemay not be able to achieve the revenue and gross margin objectives necessary toachieve positive cash flow or profitability without obtaining additional equityfinancing.  We do not currently have anyarrangements for additional financing and we may not be able to secureadditional debt or equity financing on terms acceptable to us, or at all, atthe time when we need such funding. Additionally, we may not have sufficient availability under our creditline when additional funds are needed. We had approximately $487,000 available to borrow on our credit line asof September 30, 2006. If our business does not generate sufficient cash flowfrom operations and sufficient future financings are not available, we may notbe able to operate or grow our business, pay our expenses when due or fund ourother liquidity needs.  Moreover, anyfinancing raised by us may restrict our business activities for future capitalraising efforts or cause dilution to our current stockholders.

15

----

We may explore thepossible acquisitions of businesses, products and technologies that arecomplementary to our existing business. We are continuing to identify and prioritize additional securitytechnologies, which we may wish to develop, either internally or through thelicensing, or acquisition of products from third parties.  While we may engage from time to time indiscussions with respect to potential acquisitions, there can be no assurancesthat any such acquisitions will be made or that we will be able to successfullyintegrate any acquired business.  Inorder to finance such acquisitions and working capital it may be necessary forus to raise additional funds through public or private financings.  Any equity or debt financings, if availableat all, may be on terms, which are not favorable to us and, in the case ofequity financings, may result in dilution to our stockholders.

Off-Balance Sheet Arrangements.

As of September 30, 2006,we did not have any significant off-balance sheet arrangements, as defined byItem 303(c)(2) of Regulation S-B.

Factors That May Affect Future Results of Operations 

Numerous factors mayaffect our business and future results of operations.  These factors include current economic andmarket conditions, the effect of military actions on government and corporatespending on information security products, spending patterns of, andappropriations to, U.S. government departments, technological changes,competition and market acceptance, acquisitions, product transitions, timing oforders, manufacturing and suppliers, reliance on outsourcing vendors and otherpartners, intellectual property and licenses, third-party products, dependenceon government customers, international operations, intellectual propertyissues, liquidity and cash resources and effects of restructuring plans andcost reductions.  The discussion belowaddresses some of these and other factors. For a more thorough discussion of these and other factors that mayaffect our business and future results, see the discussion under the caption “FactorsThat May Affect Future Results of Operations” in our Annual Report on Form 10-KSBfor the year ended December 31, 2005.

***Ourcash, cash equivalents, and investments decreased from $3.3 million atDecember 31, 2005 to $0.3 million at September 30, 2006 due toresults of operations.  If our net cashoutflows continue, we may not have sufficient cash to operate our business.***

As of September 30,2006, we had cash, cash equivalents and investments in the amount ofapproximately $0.3 million, down from approximately $3.3 million as ofDecember 31, 2005.  Our existingcash resources, line of credit and revenues for the remainder of 2006 and 2007,may not provide sufficient cash resources to finance our operations andexpected capital expenditures for the next twelve months.  Therefore, it is possible that we will needto seek additional debt or equity financing to fund our operations for the nextyear.  Despite actions to reduce ourcosts and improve our profitability, our operating losses and net operatingcash outflows may continue through the fourth quarter of 2006 and into2007.  As a result, we may not be able toachieve the revenue and gross margin objectives necessary to achieve positivecash flow or profitability without obtaining additional equity financing.  We do not currently have any arrangements foradditional financing and we may not be able to secure additional debt or equityfinancing on terms acceptable to us, or at all, at the time when we need suchfunding.  If our business does notgenerate sufficient cash flow from operations and sufficient financingresources are not available, we may not be able to operate or grow ourbusiness, pay our expenses when due or fund our other liquidity needs.  We may not have sufficient availability underour credit line when we need additional funds. We had approximately $487,000 available to borrow on our credit line asof September 30, 2006.  Furthermore, wemay not be able to secure additional debt or equity financing on terms that areacceptable to us, or at all, on a timely basis. Therefore, if our business does not generate sufficient cash flow fromoperations and sufficient financing resources are not available, we may not beable to operate or grow our business, pay our expenses when due or fund ourother liquidity needs.

***OurCommon Stock is Traded on the “Over-the-Counter Bulletin Board,” Which mayinvolve certain risks not present in all securities and May Make it MoreDifficult For Investors to Resell Their Shares Due to Suitability Requirements.***

Our common stockis currently traded on the Over the Counter Bulletin Board (OTCBB) where weexpect it to remain for the foreseeable future. Bulletin Board Securities are over-the-counter securities and, althoughthe NASD oversees the OTCBB, the OTCBB is not part of the NASDAQ market.  Market makers of Bulletin Board securitiesare unable to use electronic means to interact with other dealers to executetrades, which can cause delays in the time it takes to interact with the marketplace.  Moreover, the market for suchsecurities is often limited, the stocks are more volatile, and the risks toinvestors are greater.  Consequently,broker-dealers often decline to trade in OTCBB stocks.  These factors may reduce the potential marketfor our common stock by reducing the number of potential investors.  This may make it more difficult for investorsin our common stock to sell shares to third parties or to otherwise dispose ofthem.  This could cause our stock priceto decline.

16

----

***If we fail torespond to rapid technological changes in the network security, dataprotection, regulated information compliance, entity identification and spywareprevention industries, we may lose customers or our products may becomeobsolete.***

The network security,data protection, regulated information compliance, entity identification andspyware prevention industries are characterized by frequent productintroductions, rapidly changing technology and continued evolution of industrystandards.  We must introduce upgrades toour products rapidly in response to customer needs, such as new computerviruses or other novel external attacks on computer networks as well as theadoption privacy and data protection laws. In addition, the nature of the network security, data protection,regulated information compliance, entity identification and spyware preventionindustries requires our products to be compatible and interoperable withnumerous security products, networking products, workstation and personalcomputer architectures and computer and network operating systems offered byvarious vendors, including our competitors. As a result, our success depends upon our ability to develop andintroduce in a timely manner new products and enhancements to our products thatmeet changing customer requirements and evolving industry and legal standards.The development of technologically advanced network security, data protection,regulated information compliance, entity identification and spyware preventionproducts is a complex and uncertain process requiring high levels ofinnovation, rapid response and accurate anticipation of technological andmarket trends.  We cannot assure you thatwe will be able to identify, develop, manufacture, market or support new orenhanced products successfully in a timely manner.  Further, the introduction of new products orproduct enhancements by us or our competitors or the adoption of new or amendedprivacy or data protection laws may shorten the life cycle of our existingproducts or cause our existing products to become obsolete.

***Ourrevenues have decreased to $3.8 million for the first nine months of 2006 from$4.9 million for the same period in 2005 and have generally decreased since2003 in connection with a shift to sales of our newer product lines. If ournetwork intrusion detection, regulated information compliance, spywareprevention and entity identification products do not achieve market acceptance,our revenues will suffer.***

We have continuedto transition our sales strategy from our lower margin SecureCom and PDSsecurity appliance products to the development and sales of our higher marginnetwork intrusion detection/prevention, regulated information compliance,entity identification and spyware products. During this transition, sales of our new products were not enough tocounteract the loss in sales associated with our older products.  As a result, our net revenues remainedrelatively constant at approximately $6.0 million in 2004 and 2005 but havedeclined in the first half of 2006 compared to the same period in 2005 due to alonger than expected sales cycle.

Our new networksecurity products, regulated information compliance systems, entityidentification and spyware products have only been in the market place for alimited period of time and may have longer sales cycles than our previousproducts.  Customer response to theseproducts may not receive broad market acceptance.  We cannot assure you that our present orfuture products will achieve market acceptance on a sustained basis.

In order toachieve market acceptance and achieve future revenue growth, we must introducecomplementary security products, incorporate new technologies into our existingproduct lines and design, develop and successfully commercialize higherperformance products in a timely manner. We cannot assure you that we will be able to offer new or complementaryproducts that gain market acceptance quickly enough to avoid decreased revenuesduring current or future product introductions or transitions.

 

17

----

***We resemble adevelopmental stage company and our business strategy may not be successful.***

From our founding in 1983until 2000, we derived substantially all of our revenue from the design,manufacture and sale of local area networking equipment.  In order to permit us to focus our resourcessolely on developing and marketing our network security products, we sold ourlocal area networking assets and related networking divisions in a series ofsales from 2000 to 2002.

As a result of thesesales, we now depend exclusively on revenues generated from the sale of ournetwork security products, which have received limited market acceptance.  Moreover, we have only recently introducedour regulated compliance and data privacy systems and our spyware preventionand entity identification products. Although initial response to these products has been positive, themarket for these products has only begun to emerge and sales of these productsmay not occur as quickly as we expect. Consequently, we resemble a developmental stage company and will facethe following inherent risks and uncertainties:

·      the need for our network securityproducts, regulated information compliance systems, data privacy protectionsystems, entity identification products and spyware prevention products toachieve market acceptance and produce a sustainable revenue stream;

·      our ability to manage costs and expenses;

·      our dependence on key personnel;

·      our ability to obtain financing onacceptable terms; and

·      our ability to offer greater value thanour competitors.

Our business strategy maynot successfully address these risks.  Ifwe fail to recognize significant revenues from the sales of our networksecurity products and regulated information compliance systems, our business,financial condition and operating results would be materially adverselyaffected.

***We incurred a netloss of $2.8 million for the nine months ended September 30, 2006 and have anaccumulated deficit of $54.9 million as of September 30, 2006.  As a result, we must generate substantiallygreater revenues from sales in order to achieve profitability and grow ourbusiness.***

We have incurredsignificant operating losses and are uncertain about our future operatingresults.  For the nine months endedSeptember 30, 2006, we incurred a net loss of $2.8 million and had anaccumulated deficit of approximately $54.9 million as of September 30,2006.  We need to generate and sustainsubstantially greater revenues from the sales of our products if we are toachieve profitability and grow our business. If we are unable to achieve these greater revenues, our losses willcontinue indefinitely, and we may never achieve or sustain profitability orgenerate positive cash flow.

***We face intensecompetition from both start-up and established companies that may havesignificant advantages over us and our products.***

The market for networksecurity solutions is intensely competitive. There are numerous companiescompeting with us in various segments of the data security markets, and theirproducts may have advantages over our products in areas such as conformity toexisting and emerging industry standards, interoperability with networking andother security products, management and security capabilities, performance,price, ease of use, scalability, reliability, flexibility, product features andtechnical support.

Ourprincipal competitors in the network intrusion prevention and detection marketinclude IBM (Internet Security Systems, Inc.), Cisco Systems, Inc.,Symantec, Inc., Network Associates, Inc., Tipping Point Technologies, adivision of 3Com Corporation, and NFR Security, Inc.  Our competitors in the regulated informationcompliance market include Vontu, Port Authority, Vericept, Reconnex, Tablus anda small number of start-up companies that entered the space within the last twoyears. Regarding the spyware prevention market, we currently directly andindirectly compete with a number of host-based spyware detection systems, suchas Ad-Aware, Spybot S&D and Spy Sweeper and some inline proxy solutionssuch as Blue Coat Systems, Inc.  Ourcurrent and potential competitors may have one or more of the followingsignificant advantages over us:

·     greater financial, technical and marketingresources;

·      better name recognition;

18

----

·      more comprehensive security solutions;

·      better or more extensive cooperativerelationships; and

·      larger customer base.

Although we believe ourproducts compare favorably to our competitors’ products and create asustainable business model, we cannot assure you that our products will achievemarket acceptance or that we will be able to compete successfully with ourexisting or new competitors.

***Military actionsmay disrupt our business by reducing spending for our products, increasing ourcosts and affecting our international operations.***

We derive a substantialportion of our revenue from sales to United States government entities,including sales to various Army bases. As a result, United States military actions or other events occurring inresponse to or in connection with them, including future terrorist attacks,actual conflicts involving the United States or its allies or military or tradedisruptions could impact our operations by:

·     reducing or delaying government, armedservice or corporate spending on our products;

·     increasing the cost and difficulty inobtaining materials or shipping products; and

·     affecting our ability to conduct businessinternationally.

Should these eventsoccur, our business, operating results and financial condition could bematerially and adversely affected.

***Our products canhave long sales and implementation cycles, which may result in us incurringsubstantial expenses before realizing any associated revenues.***

The sale andimplementation of our products to large companies and government entities typicallyinvolves a lengthy education process and a significant technical evaluation andcommitment of capital and other resources. This process is also subject to the risk of delays associated withcustomers’ internal budgeting and other procedures for approving capitalexpenditures, deploying new technologies within their networks and testing andaccepting new technologies that affect key operations.  As a result, sales and implementation cyclesfor our products can be lengthy, and we may expend significant time andresources before we receive any revenues from a customer or potentialcustomer.  Our quarterly and annualoperating results could be materially harmed if orders forecasted for aspecific customer for a particular period are not realized.

***Our failure to realize the expected benefits of our recentrestructuring efforts could adversely affect our operating results.***

Since we beganrestructuring in 2002, we have incurred approximately $1.1 million inrestructuring charges, severance, and related expenses. The objective of ourrestructuring plan was to reduce our cost structure to a sustainable level thatis consistent with our current cash resources and the general economicclimate.  We have also implemented other strategicinitiatives to strengthen our operations, such as reductions in our work forceand facilities and aligning our organization around our businessobjectives.  Any further work forcereductions could result in temporary reduced productivity of our remainingemployees.  Additionally, our customersand prospects may delay or forgo purchasing our products due to a perceiveduncertainty caused by our restructuring and other changes.  Failure to achieve the desired results of ourinitiatives could seriously harm our business, results of operations andfinancial condition.

***Consolidation in the network security industry may limitmarket acceptance of our products.***

Several of ourcompetitors have acquired security companies with complementary technologies inthe past.  We expect consolidation in thenetwork security industry to continue in the future.  These acquisitions may permit our competitorsto accelerate the development and commercialization of broader product linesand more comprehensive solutions than we currently offer.  Acquisitions of vendors or other companieswith which we have a strategic relationship by our competitors may limit ouraccess to commercially significant technologies.  Further, business combinations in the networksecurity industry are creating companies with larger market shares, customerbases, sales forces, product offerings and technology and marketing expertise,which may make it more difficult for us to compete.

19

----

***Sales to governmententities accounted for 71.8% of our revenues for the nine months endedSeptember 30, 2006 and 70.7% of our revenues for the year endedDecember 31, 2005.  Sales togovernment customers involve unique risks, which could adversely impact ourrevenues.***

We derived 71.8% of ourrevenues from sales to various U.S. government entities for the nine monthsended September 30, 2006, and 70.7% of our revenues from these sales for theyear ended December 31, 2005.  Weexpect to continue to derive a substantial portion of our revenues from U.S.government customers in the future. Sales to the government present risks in addition to those involved insales to commercial customers, including potential disruption due toappropriation and spending patterns and the government’s right to cancelcontracts and purchase orders for its convenience.  General political and economic conditions,which we cannot accurately predict, may affect the quantity and allocation ofexpenditures by federal departments.  Inaddition, obtaining government contracts may involve long purchase and paymentcycles, competitive bidding, qualification requirements, delays or changes infunding, budgetary constraints, political agendas, extensive specificationdevelopment and price negotiations and milestone requirements.  Each government entity also maintains its ownrules and regulations with which we must comply and which can varysignificantly among departments.  As aresult, cutbacks or re-allocations in the federal budget or losses ofgovernment sales due to other factors could have a material adverse effect onour revenues and operating results.

***We derived 10.5% ofour revenues from international sales in the nine months ended September 30,2006, and 10.7% of our revenues from these sales for the year endedDecember 31, 2005.  Our ability tosell our products internationally is subject to certain risks which could harmour business.***

Sales to foreigncustomers accounted for approximately 10.7% of our revenues for the year endedDecember 31, 2005, and 10.5% of our revenues for the nine months endedSeptember 30, 2006.  We expect sales toforeign customers to continue to represent a significant portion of ourrevenues in the future.  Ourinternational operations are subject to many inherent risks that may adverselyaffect our business, financial condition and operating results, including:

·      political, social and economicinstability;

·      trade restrictions;

·      increases in duty rates and otherpotentially adverse tax consequences;

·      exposure to different legal standards,particularly with respect to the protection of intellectual property;

·      burdens of complying with a variety offoreign laws;

·      unexpected changes in regulatoryrequirements;

·      import and export license requirements andrestrictions of the United States and each other country where we operate;

·      fluctuations in currency exchange rates;and

·      changes in local purchasing practices,including seasonal fluctuations in demand.

***Sales throughindirect channels accounted for 19.2% of our revenues for the nine months endedSeptember 30, 2006 and 36.2% of our revenue for the year ended December 31,2005.  Our revenues will suffer if we donot expand our sales through, or receive the anticipated benefits from oursales through, indirect sales channels.***

We derived 19.2% of ourrevenues for the nine months ended September 30, 2006, and 36.2% of our revenuefor the year ended December 31, 2005, from sales through indirect saleschannels, such as distributors, value added resellers, system integrators,original equipment manufacturers and managed service providers.  We believe we must expand our sales throughthese indirect channels in order to increase our revenues.  Although we are actively pursuing a strategyto increase the percentage of our revenues generated through these indirectsales channels, we cannot assure you that our products will gain marketacceptance in these indirect sales channels or that sales through theseindirect sales channels will increase our revenues as expected.  Further, many of our competitors are alsotrying to sell their products through these indirect sales channels, whichcould result in lower prices and reduced profit margins for sales of ourproducts.

20

----

***We must adequatelyprotect our intellectual property in order to prevent loss of valuableproprietary information.***

We rely on a combinationof patent, copyright, trademark and trade secret laws, confidentialityprocedures and non-disclosure agreements to protect our proprietarytechnology.  However, unauthorizedparties may attempt to copy or reverse engineer aspects of our products or toobtain and use information that we regard as proprietary.  Policing unauthorized use of our products isdifficult, and we cannot be certain that the steps we have taken will preventmisappropriation of our intellectual property. This is particularly true in foreign countries where the laws may notprotect proprietary rights to the same extent as the laws of the United Statesand may not provide us with an effective remedy against unauthorized use.  If our protection of our intellectual propertyproves to be inadequate or unenforceable, others may be able to use ourproprietary developments without compensation to us, resulting in potentialcost advantages to our competitors.

***We may incursubstantial expenses defending ourselves against claims of infringement.***

There are numerous patentsheld by many companies relating to the design and manufacture of networksecurity systems.  It is possible thatthird parties in the future may claim that our products infringe on theirintellectual property rights.  Any claim,with or without merit, could consume our management’s time, result in costlylitigation, cause delays in sales or implementations of our products or requireus to enter into royalty or licensing agreements.  Royalty and licensing agreements, if requiredand available, may be on terms unacceptable to us or detrimental to ourbusiness.  Moreover, a successful claimof product infringement against us or our failure or inability to license theinfringed or similar technology on commercially reasonable terms couldseriously harm our business.

***Fluctuations in ourquarterly revenues may cause the price of our common stock to decline.***

Our operating resultshave varied significantly from quarter to quarter in the past, and we expectour operating results to vary from quarter to quarter in the future due to avariety of factors, many of which are outside of our control.  Although our revenues are subject tofluctuation, significant portions of our expenses are not variable in the shortterm, and we cannot reduce them quickly to respond to decreases inrevenues.  Therefore, if revenues arebelow our expectations, this shortfall is likely to adversely anddisproportionately affect our operating results.  Accordingly we may not attain positiveoperating margins in future quarters. Any of these factors could cause our operating results to be below theexpectations of securities analysts and investors, which likely wouldnegatively affect the price of our common stock.

***The price of ourcommon stock has been volatile in the past and may continue to be volatile inthe future due to factors outside of our control.***

The market price of ourcommon stock has been highly volatile in the past and may continue to bevolatile in the future.  For example, forthe nine-month period ending September 30, 2006, the market price of our commonstock fluctuated between $0.25 and $2.87 per share.  The market price of our common stock mayfluctuate significantly in response to a number of factors, many of which areoutside our control, including:

·     variations in our quarterly operatingresults;

·      changes in estimates of our financialperformance by securities analysts;

·      changes in market valuations of ourcompetitors;

·      announcements by us or our competitors ofnew products, significant contracts, acquisitions, strategic relationships,joint ventures or capital commitments;

·      product or design flaws, product recallsor similar occurrences;

·      additions or departures of key personnel;

·      sales of common stock in the future; and

·      fluctuations in stock market prices andvolume, which can be particularly common among network security and other hightechnology companies.

 

21

----

***Our reductions inour work force may make it more difficult for us to attract and retain thepersonnel necessary to successfully operate our business.***

We rely upon thecontinued service of a relatively small number of key technical, sales andsenior management personnel.  Our futuresuccess depends on retaining our key employees and our continuing ability toattract, train and retain other highly qualified technical, sales andmanagerial personnel.  As a result, ouremployees could resign with little or no prior notice.  We may not be able to attract, assimilate orretain other highly qualified technical, sales and managerial personnel in thefuture, especially given our recent reductions in force.  The loss of any of our key technical, salesand senior management personnel or our inability to attract, train and retainadditional qualified personnel could seriously harm our business.

***Certainrights of the holders of our preferred stock and the terms of our securedcredit line may hinder our ability to raise additional financing.***

We cannot issueshares of capital stock with rights senior to those of our existing 5%preferred stock, Series 2 5% preferred stock or Series 3 5% preferred stockwithout the approval of at least a majority of the holders of our 5% preferredstock, all of the holders of our Series 2 5% preferred stock, and holders of atleast 75% of our Series 3 5% preferred stock voting or acting as separateclasses.  We also cannot incur certainindebtedness without the approval of at least a majority of the holders of our5% preferred stock.  In addition, holdersof the Series 3 5% preferred stock who are not executive officers or directorshave the right to purchase a pro rata portion of certain future issuances ofsecurities by us.  Furthermore, the termsof our secured credit line with Silicon Valley Bank include covenants whichrestrict our ability to incur additional debt and pay certain dividends.  The combination of these provisions couldhinder or delay our ability to raise additional debt or equity financing.

***You will experiencesubstantial dilution upon the conversion or redemption of the shares ofpreferred stock and exercise of warrants that we issued in recent privateplacements.***

On March 25, 2004,we completed a $5,000,000 private placement in connection with which we issued1,000,000 shares of our 5% Convertible Preferred Stock and warrants to acquire556,619 shares of our common stock.  Theconversion price for the preferred stock and the exercise price of the warrantsis $3.144 per share.  We also issued ourplacement agent a warrant for 64,408 shares of our common stock at an exerciseprice of $3.144 per share.  As ofNovember 1, 2006, there were 259,696 shares of 5% preferred stock, representingapproximately 413,003 shares of common stock upon conversion, and warrants topurchase 621,027 shares of common stock outstanding.

In addition, onMarch 28, 2005, we completed a $2,663,000 private placement in connection withwhich we issued 1,065,200 shares of our Series 2 5% Convertible Preferred Stockand warrants to acquire 532,600 shares of our common stock.  We also issued two affiliates of ourplacement agent warrants to purchase an aggregate of 60,390 shares of commonstock.  The conversion price for thepreferred stock is $2.50 per share and the exercise price of the warrants is$2.77 per share.  As of November 1, 2006,there were 460,000 shares of Series 2 5% preferred stock, representing 460,000shares of common stock upon conversion, and warrants to purchase 592,990 sharesof common stock outstanding.

Finally, onDecember 2, 2005, we completed a $1,230,843 private placement in connectionwith which we issued 564,607 shares of our Series 3 5% preferred stock andwarrants to acquire 282,306 shares of our common stock.  We also issued two affiliates of ourplacement agent warrants to purchase an aggregate of 27,531 shares of commonstock.  The conversion price of thepreferred stock is $2.18 per share and the exercise price of the warrants is$2.58 per share.  As of November 1, 2006,there were 468,735 shares of Series 3 5% preferred stock, representing 468,735shares of common stock upon conversion, and warrants to purchase 309,837 sharesof common stock outstanding.

On November 1,2006, we had 7,046,213 shares of common stock outstanding.  We expect the private placements discussedabove to result in a further dilution to holders of our common stock uponconversion of the preferred stock and exercise of the warrants of 2,865,592shares of common stock, or an approximately 40.7% increase in the number ofshares of our common stock outstanding.

22

----

Further, theoccurrence of certain events entitle holders of our Series 3 5% preferred stockto require us to redeem their shares for a number of shares of our common stockequal to the redemption price divided by 75% of the ten-day average of thevolume weighted average price of our common stock ending on the day immediatelypreceding the holder’s election to redeem, subject to a floor of $0.87 pershare.  Holders of our Series 2 5%preferred stock have similar redemption rights without a floor.  The redemption price for the shares of Series3 5% preferred stock equals the sum of (1) the greater of $2.834 and the volumeweighted average price of our common stock on the trading day immediatelypreceding the redemption event multiplied by $2.18 divided by the conversionprice of the Series 3 5% preferred stock then in effect plus (2) any accruedbut unpaid dividends on the Series 3 5% preferred stock plus (3) anyunpaid liquidated damages or other amounts payable to the holders of the Series3 5% preferred stock.  The redemptionprice for the shares of Series 2 5% preferred stock equals the sum of (1) thegreater of $3.25 and the volume weighted average price of our common stock onthe trading day immediately preceding the redemption event multiplied by $2.50divided by the conversion price of the Series 2 5% preferred stock then ineffect plus (2) any accrued but unpaid dividends on the Series 2 5% preferredstock plus (3) any unpaid liquidated damages or other amounts payable tothe holders of the Series 2 5% preferred stock. As a result, assuming we have paid all liquidated damages and otheramounts to the holders, accrued but unpaid dividends on October 27, 2006 of $17,000,a volume weighted average price of $0.29, which was the ten-day volume weightedaverage closing price of our common stock on October 27, 2006, and our7,046,213 shares of common stock outstanding on October 27, 2006, we wouldissue approximately 13,107,000 shares of our common stock if a specifiedredemption event occurs and all holders of Series 3 5% preferred stock andSeries 2 5% preferred stock elected to redeem their shares for commonstock.  This would represent an increaseof approximately 186% in the number of shares of our common stock as of October27, 2006.

***The conversion ofpreferred stock or exercise of warrants we issued in our recent privateplacement may cause the price of our common stock to decline.***

The holders of theshares of our 5% preferred stock and warrants we issued on March 25, 2004,may freely convert their shares of preferred stock and exercise their warrantsand sell the underlying shares of common stock pursuant to an effectiveregistration statement we filed on August 6, 2004.  As of October 27, 2006, 740,304 shares ofpreferred stock had converted into 1,177,327 shares of common stock.

The holders of theshares of Series 2 5% preferred stock and warrants we issued on March 28,2005, may freely convert their shares of preferred stock and exercise theirwarrants and sell the underlying shares of common stock pursuant to aneffective registration statement we filed on May 5, 2005.  As of October 27, 2006, 605,200 shares ofSeries 2 5% preferred stock had converted into 605,200 shares of common stock.

The holders of theshares of Series 3 5% preferred stock and warrants we issued on December 2,2005, may freely convert their shares of preferred stock and exercise theirwarrants and sell the underlying shares of common stock pursuant to aneffective registration statement we filed on January 5, 2006.  As of October 27, 2006, 95,872 shares ofSeries 3 5% preferred stock had converted into 95,872 shares of common stock.

For the four weeksended on October 27, 2006, the average daily trading volume of our common stockwas 36,080 shares.  Consequently, ifholders of preferred stock or warrants elect to convert their remaining sharesor exercise their warrants and sell a material amount of their underlyingshares of common stock on the open market, the increase in selling activitycould cause a decline in the market price of our common stock.  Furthermore, these sales, or the potentialfor these sales, could encourage short sales, causing additional downwardpressure on the market price of our common stock.

***The payment of accrued dividends on our preferred stock maystrain our cash resources.***

Shares of our 5%preferred stock accrue cash dividends equal to $0.25 per share per annum,payable in arrears on March 31 and September 30 of each year, shares of ourSeries 2 5% preferred stock accrue cash dividends equal to $0.125 per share perannum, payable in arrears on the first business day of March, June, Septemberand December of each year and shares of our Series 3 5% preferred stock accruecash dividends equal to $0.109 per share per annum, payable in arrears on thefirst business day of March, June, September and December of each year.  The amount of the dividends on our Series 25% preferred stock may increase to $0.45 per share per annum and the amount ofthe dividends on our Series 3 5% preferred stock may increase to $0.3294 pershare per annum upon the occurrence of certain event entitling the holders ofthese shares to redemption.

During 2005, wepaid $123 thousand in dividends related to our 5% convertible preferred stockand $63 thousand in dividends related to our Series 2 5% preferred stock.  At September 30, 2006, we had $32,551dividends accrued related to our 5% preferred stock, $4,726 related to ourSeries 2 5% preferred stock, and $4,199 related to our Series 3 5%preferred stock.

23

----

Delaware lawprovides that we may only pay dividends out of our capital surplus or, if nosurplus is available, out of our net profits for the fiscal year the dividendis declared and/or the preceding fiscal year. We have not had net profits for the last two fiscal years ended as ofDecember 31, 2005.  However, we did havesufficient capital surplus, defined as the amount by which our net assetsexceed our stated capital, based on par value of our outstanding shares asprovided by Delaware law.  Although weare currently able to pay accrued dividends on our outstanding shares ofpreferred stock, we cannot assure you that our net assets will continue toexceed our stated capital or that we will have net profits in order to paythese dividends in the future.  Thesedividends continue to accrue on our outstanding shares of preferred stock,regardless of whether we are legally able to pay them.  The accrual of these dividends may adverselyaffect our operating results.  Moreover,the payment of these dividends could strain our available cash resources, whichcould adversely affect our ability to operate or grow our business.

In addition, ourinability to pay dividends could require us to redeem outstanding shares ofSeries 2 5% preferred stock and Series 3 5% preferred stock for shares of ourcommon stock issued at a price equal to 75% of the average of the volumeweighted average price of our common stock for the ten days ending on the dayimmediately preceding an election to redeem, subject, in the case of the Series3 5% preferred stock, to a floor of $0.87. As a result, the issuance, or potential issuance, of these additionalshares of common stock could cause our stock price to decline.  Furthermore, our inability to pay dividendscould adversely affect our ability to raise equity financing in the future ifrequired.

***Our acquisition ofcomplementary products or businesses may adversely affect our financialcondition.***

We have made acquisitionsin the past, and, in the future, we may acquire or invest in additionalcompanies, business units, product lines or technologies to accelerate thedevelopment of products and sales channels complementary to our existingproducts and sales channels.  Negotiationof potential acquisitions and integration of acquired products, technologies orbusinesses could divert our management’s time and resources.  Future acquisitions could cause us to issueequity securities that would dilute your ownership of us, incur debt orcontingent liabilities, amortize intangible assets or write off in-processresearch and development, goodwill and other acquisition-related expenses thatcould seriously harm our financial condition and operating results.  Further, if we are not able to properlyintegrate acquired products, technologies or businesses with our existingproducts and operations, train, retain and motivate personnel from the acquiredbusiness or combine potentially different corporate cultures, we may notreceive the intended benefits of our acquisitions, which could adversely affectour business, operating results and financial condition.

***Compliance withexport regulations may hinder our sales to foreign customers.***

Certain of our datasecurity products incorporate encryption and other technology that may requireclearance and export licenses from the U.S. Department of Commerce under UnitedStates export regulations.  Any inabilityto obtain these clearances or licenses or any foreign regulatory approvals, ifrequired, on a timely basis could delay sales and have a material adverseeffect on our operating results.

***Provisions of ourcharter documents and Delaware law may have anti-takeover effects.***

Certain provisions of ourcertificate of incorporation and bylaws, such as our ability to offer “blankcheck” preferred stock and the inability of our common stockholders to act bywritten consent, could make it more difficult for a third party to acquire us,even if doing so would be beneficial to our stockholders.  We are also subject to the provisions ofSection 203 of the Delaware General Corporation Law, which restrictscertain business combinations with interested stockholders and could inhibit anon-negotiated merger or other business combination.

***Our management andpreferred stockholders exercise significant control over our company and mayapprove or take actions that may be adverse to your interests.***

As of October 27, 2006,our executive officers, directors and preferred stockholders beneficially ownapproximately 23.5% of our voting power. As a result, these stockholders will be able to exercise significantcontrol over all matters requiring stockholder approval, including the electionof directors and the approval of significant corporate transactions, whichcould delay or prevent someone from acquiring or merging with us or providingus with additional financing if required. These stockholders may use their influence to approve or take actionsthat may be adverse to your interests.

 

24

----

Item 3.           CONTROLS AND PROCEDURES

Ourmanagement, with the participation of our Chief Executive Officer and ChiefFinancial Officer, has evaluated the effectiveness of our disclosure controlsand procedures (as such term is defined in rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of theend of the period covered by this report.  Based on that evaluation, ourChief Executive Officer and Chief Financial Officer have concluded that, as ofthe end of such period, our disclosure controls and procedures are effective toensure that information required to be disclosed by us in the reports that wefile or submit under the Exchange Act is recorded, processed, summarized andreported, within the time periods specified in the SEC’s rules and forms. Information required to be disclosed by us in the reports we file or submitunder the Exchange Act is accumulated and communicated to management, includingour principal executive and principal financial officers, as appropriate toallow timely decisions regarding required disclosure.

Therehave not been any changes in our internal control over financial reporting (assuch term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)that occurred during the period covered by this report that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

**PART II — OTHER INFORMATION**

Item 1.           LEGAL PROCEEDINGS

We are subject to legalproceedings and claims that arise in the ordinary course of business.  We do not believe that the outcome of thosematters will have a material adverse affect on our consolidated financialposition, operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact.

Item 6.           EXHIBITS

The following Exhibits are filed with this report form10-QSB:
| 31.1 |   | Certification of Chief Executive Officer Pursuant to  Rule 13a-14(a) of the Exchange Act.                                                                                                             |
|------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification of Chief Financial Officer Pursuant to  Rule 13a-14(a) of the Exchange Act.                                                                                                             |
| 32.1 |   | Certification of Chief Executive Officer Pursuant to  Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2 |   | Certification of Chief Financial Officer Pursuant to  Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

25

----

**S I G N A T U R E S**

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.
|                         |   | **INTRUSION INC.**                                                  |   |
|-------------------------|--------|---------------------------------------------------------------------|--------|
|                    |   |                                                                |   |
| Date: November 13, 2006 |   | /s/ G. Ward Paxton                                                  |   |
|                    |   | G. Ward Paxton                                                      |   |
|                    |   | Chairman, President & Chief Executive Officer                   |
|                    |   | (Principal Executive Officer)                                       |   |
|                    |   |                                                                |   |
|                    |   |                                                                |   |
| Date: November 13, 2006 |   | /s/ Michael L. Paxton                                               |   |
|                    |   | Michael L. Paxton                                                   |   |
|                    |   | Vice President, Chief Financial Officer,  Treasurer & Secretary |
|                    |   | (Principal Financial & Accounting Officer)                      |

 

26

----